Money Markets

Financial Institutions - FIN 4303 Fall 2011

Money Markets AMV 2011

Financial Institutions FIN 4303 p. 1/20

Overview
Money Markets Overview Fed-funds U.S. Treasury bills Negotiable CDs Commercial paper Players

Short-term end of the yield curve market ~ under

1 year maturity.
Few high quality (i.e., low credit risk) issuers. Large network of dealers and brokers. OTC wholesale market centered in New York

city.
Standardized and highly marketable securities --

one security is a close substitute for another.

Electronic book-keeping of securities and

settlement done through Fedwire.

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Overview (cont.)
Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

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Overview (cont.)
Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

The money market (MM) is a market for

liquidity

Liquidity is sold investing in MM securities. Liquidity is bought by issuing securities

(borrowing).

Liquidity condition of the banking sector is

reflected in this market.

operations.

Provides a channel for the Feds open market Leading indicator of current and future

credit/economic conditions.

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The Federal Funds Market

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Characteristics: Fedwire operates from 21:00 (previous calendar day) to 18:30 (next calendar day).
Funds can borrowed/lent through a

correspondent bank. No transfer of funds, just an accounting re-classification in balance sheet. Transfer of funds is done through Fedwire and the Federal Reserve keeps electronic bookkeeping of transactions. Fedwire transfers with a volume of 150 Billion USD. 80% of this volume is brokered.
Financial Institutions FIN 4303 p. 5/20

Funds are brokered between two institutions.

Fed-funds market accounts for 25% of total

Money Markets AMV 2011

The Federal Funds Market

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Microstructure of the market: Banks with less than 250 Million USD in assets are typically net sellers of funds.
Large banks are typically net buyers of funds.

However, half of this number are also net sellers more than half of the time.

The market is highly concentrated.

Small banks sell early in the morning. Large banks pool funds and re-sell them in the

afternoon.

Marginal fee for overdraft is 36 bps.

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The Federal Funds Market

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

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U.S. Treasury bills

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Characteristics: Sold on a discount basis (Zero-coupons).

Maturities up to one year. Minimum denomination is usually $10,000,

but smaller investors can invest in multiples of $1,000 through the Treasury Direct Program.

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U.S. T-bills - quotes

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

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U.S. T-bills - pricing

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Pricing Treasury bills Treasury bills are priced on a bank discount rate basis, a traditional yield calculation.
The discount rate yd is:

Par Price 360 y 100% d Par Days To Maturity

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U.S. T-bills pricing (cont.)

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

The Wall Street Journal lists T-bill yields on

a bond equivalent basis where the discounted price is the denominator and 365 days is used as the annualizer.

Par Pr ice 365 y 100 % bey Price Days To Maturity

The effective annual yield assuming annual

compounding is:
Effective Yield = [(Face Value/Price)365/D -1] x 100%.

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U.S. T-bills - auctions

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Weekly sale of treasuries in the primary

market by the U. S. Treasury of three- and six-month T-bills; longer-term T-bills are sold monthly or quarterly.
both on a competitive and noncompetitive basis.

T-bills are sold through an auction process

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U.S. T-bills auctions (cont.)

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Competitive Bids
Bidder specifies price and quantity desired. Minimum $10,000, in multiples of $5,000

above $10,000.
Mostly primary dealers & banks. No more than 35 % of the issue is sold on a

competitive basis to one bidder in order to ensure a competitive secondary market.

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U.S. T-bills auctions (Cont.)

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Non-competitive Bids
All non-competitive bids are accepted.
Bidder only specifies the quantity. Maximum $1,000,000. Mostly individuals & small investors. Pays price of competitive bids accepted.

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Electronic book entry process

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

No transfer of physical securities: only

electronic record entries in the district Federal Reserve bank.

Book-entry record keeping. Most of marketable Treasury debt is now in

electronic book- entry form.

Participants in Treasury Direct program

have electronic book-entry accounts.

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Negotiable CDs
Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Characteristics of Negotiable CDs

Large denomination time deposits with less than

six month's maturity.

Can be sold and traded before maturity. Interest computed on a 360 day year. Secondary market deals are for $1 million or more. Payment between banks through fed funds

market.

Interest rates on CDs are higher than on T-bills

due to higher credit risk, lower marketability, and higher taxability.

Financial Institutions FIN 4303 p. 16/20

Money Markets AMV 2011

Negotiable CDs (cont.)

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Development of the CD Market

By Citibank in 1961. Offsetting disintermediation process with demand

deposits.

The CD Market
Interest rate is negotiated between the buyer and the

seller.

Interest rate is usually lower for money center banks,

and tiered upward for regional banks.

Purchased mainly by corporate businesses.

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Commercial Paper (CP)

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Maturity up to 270 days. Unsecured debt (Now guaranteed by Fed). Large denominations > $100,000. Issued by high quality (low default risk)

borrowers (Mostly finance companies).

retail investors. T-bill).

A wholesale money market instrument - few

Sold at a discount from par (same pricing as

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CP (cont.)
Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

Credit ratings are very important for

commercial papers.
Backup lines of credit from banks support

or guarantee of repayment.
Placement Directly by the sales force of the borrowing firm. Indirectly through underwriting process.

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Financial Institutions FIN 4303 p. 19/20

Money market players

Money Markets Overview Fed-funds market U.S. Treasury bills Negotiable CDs Commercial paper Players

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